What Is ICE LIBOR And What Is It Used For?

By Greg McFarlane AAA

As a rule, when a financial term consists of nothing more than an acronym followed by another acronym, it’s easy to lose sight of what it represents, and of how large an effect it can have on our day-to-day financial lives. In the case of ICE LIBOR, an innocent-sounding set of letters has a profound bearing on every loan you make.

ICE LIBOR is the average of the interest rates that some of the world’s leading banks charge each other for short-term loans.  It stands for Intercontinental Exchange London Interbank Offered Rate (Yes, technically that should be I LIOR, or perhaps IE LIOR, but the additional consonants are supposed to make it easier to pronounce). As for Intercontinental Exchange (ICE), it’s the parent company of the New York Stock Exchange and a couple dozen other exchanges and markets around the world. ICE took over administration of LIBOR from the British Bankers Association in early 2014. (See also "Will IOS Replace LIBOR?")

LIBOR (in common parlance, the “ICE” is often dropped) serves as the first step to calculating interest rates on various loans throughout the world. There are actually several LIBORs: every morning ICE issues benchmark rates for loans in five currencies, for seven maturities. The currencies are the U.S. dollar, pound sterling, euro, Japanese yen and Swiss franc; and the maturities are overnight, one week, and 1, 2, 3, 6 and 12 months. While that makes for 35 different LIBORs, the one most commonly quoted is the 3-month dollar rate. If you hear someone referring to “today’s LIBOR” without further qualification, it’s safe to assume that it’s the 3-month dollar rate they’re referring to.  

LIBOR’s practical applications are universal. The rate is included by name in the standard language of many loan documents, and its influence ranges from the advanced realm of swaps and derivatives to more commonplace concerns such as student loans and mortgages. Once you’re approved, you pay a going rate, plus a few basis points’ worth of LIBOR A decrease in LIBOR should result in a few dollars saved on any subsequent home loan, whether that loan is either directly or implicitly tied to LIBOR.

One reason why Intercontinental Exchange stresses use of the full term “ICE LIBOR” is that its calculation today differs from that during its previous existence under the purview of the British Bankers’ Association. Back then LIBOR was released for an additional five currencies, and for an additional eight maturities. Furthermore, BBA calculated the rate by examining and averaging the rates charged by its 200-odd member banks worldwide. This made for a fair consensus rate, or would have if one influential member bank’s group chairman (who, purely coincidentally, was the BBA’s chairman emeritus) hadn’t authorized made-up numbers for LIBOR’s daily calculations. In fact, there were several BBA member banks that conjured rates out of the ether. After the scandal went public in 2012, LIBOR needed a new home.

Since ICE cleaned LIBOR’s house, the number of contributing banks is fewer than 20. Which would seem to be counterintuitive and offer the potential for wide variance, except that the remaining banks now have greater incentive to be honest. Plus they report to a governing body with less tolerance for skullduggery.

Rates rarely change by more than a basis point on any given day. The current 3-month dollar LIBOR hovers around 0.23%. Like the 34 other LIBORs, that’s either a historic nadir or very close to it. It’s also about one-twentieth of the level the 3-month dollar LIBOR was at in early 2008.

Of course, rates barely above zero are what the banks that contribute to LIBOR charge their best customers; which is to say, each other. Most of us aren’t institutions in the habit of borrowing multimillion-dollar sums of cash from other institutions, and thus entitled to borrow at minuscule rates. For the smaller loans that most of us make, on everything from our charge cards to our home equity lines of credit, LIBOR serves as the substructure for the actual interest rate. The 29.78% you’re paying because you failed to read the fine print on your MasterCard (MA) agreement was most likely calculated with respect to whatever level LIBOR was at when you applied for the card.

How does LIBOR differ from other major benchmarks, such as the federal funds rate proclaimed by Federal Reserve Board chairwoman Janet Yellen? Well, the latter is announced every few weeks instead of daily. Also, the federal funds rate is an instrument of a nation’s monetary policy. When the Fed decides that the time is opportune to augment or diminish the money supply, or its growth rate, lowering or raising the federal funds rate is one way to accomplish that. Meanwhile LIBOR is obviously international in scope, and is supposed to be more a metric of what interest rates are, rather than what one country’s central bank believes they ought to be.

On the other hand, both rates are in point of fact based on opinion rather than hard data. If that sounds overly cynical, it isn’t. For purposes of calculating LIBOR, ICE submits a questionnaire to its member banks that includes the following open-ended query, subject to the respondent’s whims:

At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11 am London time?

Thus the composition of ICE LIBOR is conditional on the objectivity of whichever bank employees are entrusted with answering the question. ICE even acknowledges that it deliberately keeps the phrase “reasonable market size” undefined and ambiguous.

Depending on the currency involved, anywhere between 11 and 18 of the member banks answer ICE’s question. ICE then ranks the banks’ rate estimates, discards the top and bottom quartiles, and takes the average of the remaining 5 to 10 rates. Presto, the result is a number that not only has an effect on the loans you make, far removed from the world’s financial centers, but that serves as a bellwether for subsequent interest rate movements.

The Bottom Line

The BBA scandal almost spelled the end of LIBOR. Fortunately, a new administrative body and a streamlined, transparent process for LIBOR’s calculation have kept this family of interest rates relevant. Given that there’s an unmistakable need for a global set of benchmark interest rates for 5 of the world’s most traded and most widely held currencies, ICE LIBOR will continue to be relevant (and applicable to everyday lenders and borrowers) for many years to come.

You May Also Like

Related Articles
  1. Investing Basics

    The Insiders Who Fix Rates for Gold, ...

  2. Investing News

    The LIBOR Scandal

  3. Investing

    Reassessing Your Approach To Bond Investing

  4. Economics

    What Is Happening To The BRIC Economies?

  5. Economics

    The Economic and Social Effects of Corruption

Trading Center